Inflation Targeting and Interest Rates

[Viking Prince]

A web site some of you might find interesting:

Project Syndicate -- Home

A recent column by Joseph Stiglitz:

The Failure of Inflation Targeting

The World’s central bankers are a close-knit club, given to fads and fashions. In the early 1980’s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited – at great cost to those countries that succumbed to it – the quest began for a new mantra.

The answer came in the form of "inflation targeting," which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation , the best response is to increase interest rates.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much impact on inflation; it will only make the task of surviving in these conditions more difficult.

I think Prof. Stiglitz has a point. I would not go so far as to ignore inflation targeting, but the risk is real and should be watched. As he said within the article:

Inflation in these countries is, for the most part, imported . Raising interest rates won’t have much impact on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, not those in developing countries, should be raised.

This requires global cooperation and not following domestic self interest. The idea is probably doomed to fail for this reason alone. It is still interesting.

[~Paine~]

I agree to a certain extent. Demand-pull inflation can be tackled with monetary policy but cost-push inflation, the likes of which we are experiencing now with rising food & oil prices, can not be effectively quelled with rises in interest rates.

Indeed, because of its ineffectiveness, it often leads to stagflation.

[Freddie]

[FONT="Comic Sans MS"][COLOR="Green"]The guy is older then me but for all of his age and experience he is not wiser.

Monetarism has been the bed rock that a lot of economies has been built on over the last 25 years. Now I live in the UK and was born in 1980, during that time Margret Thatcher was in power and was revolution our economy by controlling out of control inflation which was a by-product of bad management, Union power and inefficient nationalised industries.

The key lesson learned during the Thatcher years was that inflation is the single greatest threat to economic stability. Now since 1994 the UK has enjoyed some the best economic growth in western Europe, had low inflation, low interest rates and low unemployment. Even today we still have the same situation which means Britain is prepared to deal the credit crunch as well as other economic factors (higher oil prices for example).

If we hadn't followed through on a monetarist policy the UK would have been bankrupt 18 years ago. Higher inflation just devalues money to argue otherwise is just dangerous.

[Viking Prince]

[font="Comic Sans MS"][color="Green"]The guy is older then me but for all of his age and experience he is not wiser.

Monetarism has been the bed rock that a lot of economies has been built on over the last 25 years. Now I live in the UK and was born in 1980, during that time Margret Thatcher was in power and was revolution our economy by controlling out of control inflation which was a by-product of bad management, Union power and inefficient nationalised industries.

The key lesson learned during the Thatcher years was that inflation is the single greatest threat to economic stability. Now since 1994 the UK has enjoyed some the best economic growth in western Europe, had low inflation, low interest rates and low unemployment. Even today we still have the same situation which means Britain is prepared to deal the credit crunch as well as other economic factors (higher oil prices for example).

If we hadn't followed through on a monetarist policy the UK would have been bankrupt 18 years ago. Higher inflation just devalues money to argue otherwise is just dangerous.

Granted. Stiglitz usually argues that the western policies adversely affect the developing world. In this case he is stating that the US should raise rates to slow the domestic economy down to lower inflation on food and energy in the third world. Partially a demand issue and partially a nominal pricing issue with US$ benchmarking many commodities.

It will not happen unless it is in the interest of the Fed and Treasury to also do so for domestic reasons. This is the flaw in the argument.

[Freddie]

Granted. Stiglitz usually argues that the western policies adversely affect the developing world. In this case he is stating that the US should raise rates to slow the domestic economy down to lower inflation on food and energy in the third world. Partially a demand issue and partially a nominal pricing issue with US$ benchmarking many commodities.

It will not happen unless it is in the interest of the Fed and Treasury to also do so for domestic reasons. This is the flaw in the argument.

I'm in fear for the US economy, just today I learned that two of major banks that secure funding for mortgages are in trouble one of which has been taken over by government officials. Apparently the US government could potentially have $5 trillion of bad or doubtful debts sitting on it's books which will devalue the $ even more driving the price of oil up even further towards $200 a barrel.

[sparty]

Ultimately the US Federal Reserve has only 1 tool which is the interest rate, but they have to address 2 problems...

By lowering the interest rate they can affect growth (potentially) by making money easier to borrow. This, however, increases the risk of inflation.

By raising the interest rate they can affect inflation by making money harder to borrow and thus more valuable. This, however, increases the risk of slowed growth.

So they have a very imperfect tool at their disposal. This week marked the final date for the stimulus checks to go in the mail. So far, this has done very little to change the course of the US Economy, but it made political gains for an embattled administration.

That balance between politics and the economy is something that the Bush administration has made clear from his very first term in office. He took a budget surplus and a wildly strong economy (I'm talking fundamentals) and by allowing special interests (credit companies and major lenders) to rule Washington he single handedly sold out the American people.

His administration's response has NOT be to take adequate steps to reduce spending, but instead to engage itself in conflicts of politics and military that further the budget imbalance.

Without a control on spending from Washington, coupled with tough economic love for lenders AND borrowers the housing surplus and consumer economic policy issues will never right themselves. Bush is essentially leaving a mess for whoever takes over for him in January.

[Admiral Piett]

Much of it really has to do with the fact that Bush cut taxes - but increased spending. It's the same mistake Reagan made in '84. What we need to do is cut spending AND taxes, not one or the other.

Also, much of the pressure we feel of inflation has a lot to do with the Federal Reserve printing money with no value.

[Freddie]

Much of it really has to do with the fact that Bush cut taxes - but increased spending. It's the same mistake Reagan made in '84. What we need to do is cut spending AND taxes, not one or the other.

Also, much of the pressure we feel of inflation has a lot to do with the Federal Reserve printing money with no value.

The last I heard infaltion was at 3% in the US, inflation is hardly soaring out of control.

[sparty]

Inflation is a reactionary force so measuring what it is today is not as important as what it is forecast at since changes in the economy don't immediately impact it.

The problem is creating a model with which you can accurately forecast. There are a number of models out there but there is a lot of debate about their accuracy.

Also 3% is an overall measure. In things like food there is the highest inflation in 15 years and in energy costs it's astronomical. So I wouldn't advocate a cavalier attitude about the health of the US Economy. For foreign readers that'd make me worried as well because the old saying "When the U.S. economy catches a cold the rest of the world gets the flu" is still quite true.

The double digit inflation from the 70's is not out of the question. With unemployment on the rise 5.5% or so and a softening demand for durable goods which are made in the US still that could further weaken the economy.

Cutting taxes AND spending is not an answer either unless you cut spending back below where it was pre-tax cuts which would eliminate a TON of services provided by the government. After all you cannot pay off a debt with money you don't make!